Charles Goodhart also pointed out the stupidity of risk weighted capital requirements for banks based on ex ante perceived risks… also with no luck!

In the very last page (540) of Charles Goodhart’s “The Basel Committee on Banking Supervision: A history of the Early Years, 1947-1997” of 2011 we read the following:

“Capital is supposed to be a buffer against unexpected loss: In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate interest margins, the use of credit ratings as a guide to risk weights for capital adequacy requirements (CARs) is wrong and inconsistent, since these give a measure of expected loss. What is needed instead is a measure of the uncertainty of such losses, the second moment rather than the first.

If capital risk weights had been based, as they should logically have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/08 financial crisis.

It remains surprisingly difficult to persuade regulators of this simple point.”

But to that Goodhart adds “It does however, get recognized from time to time”… though the examples he then indicates, are not so clear.

In the Epilogue (page 581) Goodhart list some of the failings of the BCBS’s regulations:

1. The lack of any theoretical basis.

2. The focus on the individual institution, rather that the system

3. The failure to reach an accord on liquidity;

4. The lack of empirical analysis;

5. The unwillingness to discuss either sanctions or crisis resolution, and so on.

That clearly adds up to a total regulatory failure... no wonder they don't want to discuss sanctions. 

But, unfortunately as I see it, Charles Goodhart, though absolutely right, is only scratching the surface. What is most dangerously ignored are the distortions in the allocation of bank credit to the real economy that these risk weighted capital requirements for banks cause.

Here is my own, also ignored, current brief aide memoire on the major mistakes with the risk weighted capital requirements

Mervyn King’s book “The end of alchemy” is dangerously incomplete and excessively praised

Mervin King, former governor of the Bank of England begins his book “The end of alchemy” by citing from “The Rock” by TS Elliot, 1934. 

The endless cycle of idea and action,

Endless invention, endless experiment,

Brings knowledge of motion, but not of stillness; 

Knowledge of speech, but not of silence; 

Where is the wisdom we have lost in knowledge? 

Where is the knowledge we have lost in information? 

From a formal statement, delivered in March 2003, as an Executive Director of the World Bank, let me extract the following: 

“In this otherwise very complete Global Development Finance 2003, there is no mention about the issue of the growing role of the Independent Credit Rating Agencies, and the systemic risks that might so be induced, when they are called to intervene and direct more and more the world’s capital flows.

With respect to Basel, we would also like to point out that the document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being it that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth.

As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like us EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.”

And some weeks later in another formal statement I insisted in my arguments and added:

“We truly have to find a way of helping the Knowledge Bank to try to evolve into something more of a Wisdom Bank, or, to put it more humbly, at least a Common Sense Bank.

Basel is getting to be a big rulebook (this was said by the Bank). And, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world, is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund”

Unfortunately though I expressed my reasoned concerns, timely, in a globally important and relevant institution, these fell on deaf ears and were unable to stop crazy Basel II from being approved in June 2004.

And that is the reason why I believe I have earned all the right to openly consider “The End of Alchemy” a very dangerously incomplete book that, equally dangerous, is being excessively praised. 

Mervyn King dedicates his book to his “four grandchildren because it is their generation who will have to develop new ways of thinking about macroeconomics and to redesign our system of money and banking if another global financial crisis is to be prevented."

While I equally dedicate, to my for the time being only two grandchildren, the fight against bank regulators who, fixated on turning the banks into safe mattresses where to stash away savings, did and do not give any consideration to the importance of banks allocating credit efficiently to the real economy, so that the economy can move forward and not stall and fall over us all.

Kings book, in 370 pages, except perhaps when discussing the “Chicago Plan” of banks’ holding 100 percent liquid reserves against deposits, and the configuration of “wide banks” financed with equity and long term debt, does not really discuss the allocation of bank credit to the real economy. That function which to me, represents the fundamental social purpose of banks. That allocation which has now been impeded by mindboggling stupid risk-weighted requirements, those which dangerously favor credit for what is perceived, decreed or concocted as safe, sovereigns, the AAArisktocracy and residential house financing over credit to those perceived as risky, like SMEs and entrepreneurs.

King's book, in 370 pages, does not mention the fact that allowing banks to hold less capital against assets perceived, decreed or concocted as safe, allows banks to earn higher expected risk adjusted returns on equity on these assets than on those perceived as risky.

But King writes “The people who designed those risk weights did so after careful thought and an evaluation of past experience”. Nonsense, they analyzed the perceived risks of bank assets, not the risk of those assets that have created bank crises.

And King follows that with “They simply did not imagine how risky mortgage lending and the sovereign debt of countries such as Greece would become during the crisis”. That clearly evidences that King does not yet understand the role the assignment of low risk weights as zero percent to sovereigns, 35 % to residential mortgages and 20% to AAA rated securities, played in helping create the dangerous excessive bank exposures to these categories.

And King follows that with: “Rather than lambast the regulators for not anticipating those events, it is more sensible to recognize that the pretense that it is possible to calibrate risk weights is an illusion” And I just have to ask, should we not lambast regulators more with the latter, as it proves their excessive hubris?

And King follows that with: “The need for banks to use equity to absorb losses is most important in precisely those circumstances where something wholly unexpected occurs” Right, that is precisely why setting capital requirement that are to cover of the unexpected based on expected credit risks, the risk most cleared for by the banks is so loony.

But at least King there concludes in that “A simple leverage ratio is a more robust measure for regulatory purposes. Good for him! Though clearly he does that only from the perspective of making banks safer, without any thought about the need for less distortions produced in the credit allocation.

In terms of TS Eliot, when it comes to making the bank system safer: 

Knowledge could, as it did, set the risk weights, based the ex ante perceptions of it. 

Wisdom would only set these based on their ex post possibilities of creating havoc. 

Knowledge can get you get started immediately on the avoidance of risks. 

Wisdom would first have you to identify, which risks you cannot afford not to take.

Where King is absolutely right is when he opines, “Regulation has become extraordinarily complex, and in ways that do not go the heart of the problem of alchemy… By encouraging a culture in which compliance with detailed regulations is a defense against a charge of wrong doing, bankers and regulators have colluded in a self-defeating spiral of complexity”

But then a much better title of the book would have been “How do we stop bank regulators from doubling down on alchemy”.

Current regulations only make banks refinance the safer past. For King’s grandchildren, and for mine, let us pray they can soon take on again their vital role in financing the riskier future.

The major mistake with current bank regulations, one that has not been rectified yet, is that the regulators never defined the purpose of banks before regulating these. In this respect, let me stop, for now, by quoting John A Shedd “A ship in harbor is safe, but that is not what ships are for.”

The regulatory powers of our bank regulators need to be urgently regulated, at least those of the Basel Committee.

What do you think the world would have said if the Basel Committee had informed it that it would regulate the banks, without considering the purpose of the banks? 

What do you think the world had said if the Basel Committee had informed that in order to make the banks safer, they were going to distort the allocation of credit to the real economy?

What do you think the world would have said if the Basel Committee had informed it that even though all major bank crises have always resulted from excessive exposures to something ex ante erroneously perceived as safe, they would allow for especially low capital requirements against bank exposures to what ex ante was perceived as safe.

What do you think the world would have said if the Basel Committee had informed it that even though the society considered that banks giving credit to SMEs and entrepreneurs was very important, they would saddle the banks with especially large capital requirements on account of those “risky” being risky.

What do you think the world would have said if the Basel Committee had informed it that it was going to assign a zero risk weight to sovereigns and a 100 percent risk weight to the citizens, and which indicated their belief that government employees could make better use of other people’s money than private citizens could use theirs. 

What do you think the world would have said if the Basel Committee had informed it that even though banks already cleared for credit risks with interest rates and size of exposure they would also require banks to clear for that same risk in the capital; and that even though any risk that is excessively considered leads to the wrong actions even if perfectly perceived.

What do you think the world would have said if the Basel Committee had informed it that because they could not estimate the unexpected losses that bank capital is primarily to cover for, they would use expected credit risks as a proxy for the unexpected.

What do we think about that even when the 2007-08 clearly evidenced the failure of the regulators, they go on as if nothing, using the same regulatory principles? I just know that neither Hollywood nor Bollywood would ever have permitted those creating the box-office flop of Basel II, to go on working on Basel III.

Sincerely, are we really sure all these regulators in the Basel Committee, and in the Financial Stability Board, are just not some Chauncey Gardiner characters?

The Basel Committee used expected credit losses as a direct proxy for all the unexpected. Loony eh?

Steven Solomon in “The confidence game” Simon and Schuster 1995 writes about “who the central bankers are, how they have shaped the course of economic and political events in the past fifteen years, why their influence relative to elected political leaders has reached a historical zenith, and how it reveals one of the greatest pressing dangers facing free democracy.

And beginning Solomon quotes The Testament of Beauty by Robert Bridges with:

Our stability is but balance, and conduct lies

In masterfully administration of the unforeseen

And later Solomon writes: “On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

And which, in other words, means that these regulators determined the capital bank needs to hold to cover for unexpected losses, was to be a direct function of the ex ante perceived risk of expected credit losses. The expected substituting for the unexpected... loony eh!

Since the expected is already considered by bankers when setting the interest rates and the size of exposures, having it to also stand in for the unexpected in the capital, meant the expected got to be excessively considered. And any risk, even if perfectly perceived, causes the wrong actions, if excessively considered. What did we do to deserve such credit risk adverse fools?

How can we foolproof our banks from being regulated by fools?

Greg Ip has written a great book “Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe”. It is on topics about which I have screamed for soon two decades; such as there is nothing as risky as excessive risk-aversion; and that going for the perfect perfectly applied to all, only creates mindboggling fragility.

Unfortunately Ip does not draw the most important conclusion his own book suggests, namely that what we have really to foolproof, is our regulatory system, so as to impede the risk-adverse to add their risk-aversion, for instance on top of our banking system. 

In 1999 in an Op-Ed I wrote: “the possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse”

And the Bang sure happened. To me it is obvious what that systemic error is, but regulators don’t want to even acknowledge the problem…and so they keep taking us down the same suicidal path, to the next even bigger Bang.

The systemic error I refer to, the pillar of bank regulations, is the credit risk weighted capital requirements. More credit risk more capital – less credit risk less capital.

And let me explain what happens using non-bank risks from data found on the web.

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

And so, undoubtedly, the risk of dying going by motorcycle seems to be about 19 times larger than by cars.

And that, translated into banking, would signify regulators requiring much higher capital when traveling on motorcycles than when travelling in cars.

But then on the web we also find these final statistics:

In 2011 in the US, 4,612 persons died in motorcycle accidents.

In 2011 in the US 32,479 persons died in vehicle accidents

And which, translated into banking, would mean that what is perceived as safer, caused about 7 times more losses than what is perceived as risky. Something logical since, as going on motorcycles is riskier, more choose going in safer cars.

Our bank regulators simply ignored that banks already cleared for credit risks, with risk premiums and amounts of exposure, and so on top of bankers’ risk aversion (see Mark Twain) they added their own risk aversion and caused the mother of all regulatory risk aversion. They never even bothered to analyze what had caused major bank crises in the past.

And there are two very tragic consequences that derives from that regulatory negligence.

First, that banks, since they could not leverage as much when lending to those going on motorcycles, are able to earn higher risk adjusted returns on equity when lending to those going by cars… they stop lending to motorcyclists… meaning our “risky” SMEs and entrepreneurs… and the economy stutters.

The second that when suddenly too many car deaths result, then banks will have little capital to cover themselves up with.

One reason Ip has not discovered this mistake, is because he mistakenly believes that “Capital serves as a shock absorber: it absorbs losses from bad loans” Not so, capital serves a shock absorber against unexpected losses not against expected credit losses. The regulators agreed with that, explicitly, but then inexplicably proceeded to estimate the unexpected with the expected… ignoring completely that what is perceived as safe has by pure logic much more potential of delivering unexpected losses than what is perceived as risky.

In Basel II, the risk weight for a private sector asset rated AAA (cars) was 20 percent… while the risk-weight for the below BB- rated (motorcycles) was 150 percent. Frankly, who in his right mind, can believe credits rated BB- are more risky to the banking system than credits rated AAA to AA? 

Ip very correctly writes: “Cost benefit analysis brings clarity and discipline to rule making… We owe it to ourselves to decide how safe we want to be though analysis, not emotion”. But what Ip has not realized, probably because its implications are so outrageous to make that believable, is that in all bank regulations there is nothing stated about the purpose of our banks, and, without that, how can you do a cost-benefit analysis?

Ip writes: “The solution for banks’ excessive risk taking as Paul Volcker saw it, was to force them to hold more capital, so that bad lending decision would not sink them”…meaning, when confusing ex ante risks with ex-post realities, that they should not lend to motorcyclist. Well no! 

Of course in Europe regulators were (are) even worse, but in the US, Volcker, Greenspan, Bernanke and from what we see Yellen… none of them have been concerned about the distortion of bank credit allocation to the real economy their regulatory pillar causes… and so when I refer to the need to foolproof bank regulations, I do include fool-proofing these against Fed Chairs too.

Here is what those who believe risk weighted capital requirement for banks is smart must be thinking.

Are you one of them?

The pillar of current bank regulations is risk weighted capital requirements for banks: More perceived credit risk more capital – less perceived credit risk less capital.

Below what those who believe risk weighted capital requirement for banks is smart, must be thinking. Are you one of them?

That though with banks so many other aspects are risky, like the possibility of cyber attacks, the only thing that matters are credit risks.

That even though banks perceive credit risks, and adjust for that with risk premiums and the size of their exposures, that’s not enough, banks must also adjust for the same perceived risks in their capital.

That lending little at high-risk premiums to something perceived risky, is riskier than lending a lot at very low risk premiums to something perceived safe.

That bankers, no matter what Mark Twain thinks, love to lend out the umbrella when it rains and abhor doing so when the sun shines.

That it is the specific credit risk of the assets that matter, and not how banks manage those risks.

That the expected credit risks are good estimators of the unexpected losses banks need to hold capital against.

That the safer an asset is perceived the less is its potential to deliver unexpected losses.

That the riskier and asset is perceived the greater is its potential to deliver unexpected losses. 

That as long as banks do not fail, the rest, like if they allocate bank credit efficiently to the real economy or not, does not matter. 

That even though a bank is required to hold more capital lending to someone perceive risky than when lending to the AAArisktocracy, that has nothing to do with inequality.

That even if a sovereign depends on its citizens, the sovereign can have a zero risk weight while the citizens, like SMEs and entrepreneur should have a 100 percent risk weight.

That though all major bank crises have occurred because of excessive exposures to what was erroneously perceived as safe, that has nothing to do with tomorrow's bank crises.

That even though no major crisis has have occurred because of excessive exposures to what ex ante was perceived as risky, that has nothing to do with tomorrow's bank crises.

That if you, to the banker’s natural risk aversion, add on the regulators natural risk aversion, you will not risk getting an excessive risk aversion that could be dangerous for the real economy.

That if the perceived credit risk is correct, it does not matter how much importance you give to that perception.

That if you play around with the odds of roulette it will survive as a viable game

What were (are) regulators in the Basel Committee smoking when they set their capital requirements for banks?

The capital requirements for banks are primarily, almost exclusively, to cover for Unexpected Losses (UL), since the Expected Losses (EL) are covered by means of risk premiums, size of exposures and other terms.

And this the bank regulators know as we read in “An Explanatory Note on the Basel II IRB Risk Weight Functions”.

It states: “Banks are expected in general to cover their EL on an ongoing basis, e.g. by provisions and write-offs, because it represents another cost component of the lending business. The UL, on the contrary, relates to potentially large losses that occur rather seldom. According to this concept, capital would only be needed for absorbing UL… [and so] it was decided to follow the UL concept and to require banks to hold capital against UL only.”

But then the strangest thing happened! The regulators, when calculating those UL decided to do this all with formulas that used the EL, and so, inexplicably, they came up with capital requirements that indicate the potential of higher UL for higher EL.

And that just cannot be. It is clear that the safer an asset is perceived, the larger its potential to deliver UL. It is also clear that many of UL in a bank can derive from causes completely unrelated to the intrinsic riskiness of assets… like for instance a cyber-attack.

And, as a result of the confusion, the current capital requirements for banks are much higher for assets perceived as “risky” than for assets perceived as “safe”, with the following consequences:

Banks are able to create huge exposures, against very little capital, to what is ex ante perceived as safe but that ex post could turn out risky, and that is precisely the stuff major bank crises are made of.

The allocation of bank credit is much distorted since using Mark Twain’s analogy bankers will now lend out the umbrella even more than usual when the sun is out and want it back faster than ever as soon as it looks like it is going to rain.

Just look at how much those in the sun, like AAA rated securities, real estate and governments (like Greece) have been able to borrow, when compared to the much tightened borrowing conditions for SMEs and entrepreneurs.

And so nowadays, thanks to our regulators, banks are not financing the riskier future but are mainly busy refinancing the safer past… Friends, where are the jobs for our grandchildren come from?

Sir Jon Cunliffe. Tiberius would have regulated banks much better than the Basel Committee.

I hereby reference a speech titled “Macroprudential policy: from Tiberius to Crockett and beyond” given on July 28 by Sir Jon Cunliffe, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee and Member of the Prudential Regulation Authority Board 

Sir Cunliffe writes: “the underlying prudential standards – the reserves of capital and liquid assets that individual banks and other firms need to hold to enable them to withstand bad times – should be set not simply in relation to the risks in the individual firm, but also to reflect the importance of the firm to the financial system and the cost to the economy as a whole if the system fails”

Indeed but it was precisely there, when defining the risks of an individual firm, that regulators completely lost it:

Instead of considering the risks of unexpected losses, and the risk that banks would not be able to clear for the perceived risks, the regulators based “the reserves of capital and liquid assets that individual banks and other firms need to hold to enable them to withstand bad times” on the expected losses derived from the perceived credit risks… the only risks that were already being cleared for by banks by means of size of exposure and risk premiums…

And, as the regulator should have known, any risk even when perfectly perceived is wrongly managed if excessively considered. And that completely distorted the allocation of bank credit to the real economy.

If you’re a kid and your parents assign two nannies to care for you, you can still live a fairly ordinary childhood if the average of your two nannies’ risk aversion is applied. But, if their two risk aversions are added up, you stand no chance, then you better forget about having a childhood.

Sir Cunliffe writes: “The financial system does not simply respond to the economic cycle, growing as the economy grows and vice versa. It also feeds on its own exuberance in good times and on its fear in bad times which can in turn drive the real economy to extremes, as we have witnessed in recent years. The underlying causes of this phenomenon are interactions, feedback loops and amplifiers that exist within the financial system that can act as turbo chargers in both directions”

Precisely and perceived credit risks, credit ratings are main feedback loops and amplifiers that exist within the financial system. In January 2003 in a letter published in FT I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.”

Sir Cunliffe writes: “recognition that what distinguishes ‘macroprudential’ from ‘microprudential’ and from ‘macroeconomic’ is its objective of financial system stability rather than the instruments it deploys.” 

Let me spell it out more directly: The best macro-prudential regulations is one of micro-prudential regulations that help banks to fail… fast… not the current micro-prudential regulation, which only helps to create too big to fail banks.

Sir Cunliffe so correctly writes: “The financial system plays a crucial role in a modern economy directing resources to where they can be most productive and can generate the greatest return. When the dynamics of the system itself distort incentives and judgments of risk and return, there can be a huge misallocation of resources in the economy. And when the bubble bursts and the economy has to adjust, a damaged financial system cannot guide the necessary reallocation of resources – indeed, as we have witnessed, it can slow it down.”

How unfortunate then that Sir Cunliffe, and his regulatory colleagues, cannot get themselves to understand that the pillar of their regulations, the portfolio invariant credit risk weighted capital requirements, is in fact the greatest source of distortion in the allocation of bank credit of them all. It guarantees the dangerous overpopulation of safe havens, as well as the equally dangerous lack of exploration of the riskier but perhaps much more productive bays.

Sir Cunliffe begins his speech by saying “Historians still argue about the exact causes of the financial crash of AD 33 that rocked the Roman Empire.” 

I guarantee him that historians will soon know perfectly well what caused the financial crash of 2008, and why it is taking so much time for the world to get out of it. And they will not be kind on the current batch of regulators. Without being clear about the crash of AD 33, they will have no doubt about that Tiberius would have known better than the Basel Committee.

Tiberius would have picked bank regulators who would have tried to understand why banks fail... not why bank clients fail. 

Tiberius would have picked bank regulators who would have known that the biggest risk for the banking system is that of not allocating bank credit efficiently to the real economy... as no bank can  remain safe while standing in the midst of the rubbles of a destroyed economy.

Where could truly dangerous really unexpected events occur the most?

REALLY UNEXPECTED? THINK IT THROUGH?

Bank capital is to be held against unexpected losses because the expected losses derived from the perceived risks are already cleared for by smaller exposures and higher risk premiums,

The Basel Committee for banking supervision considered the dangerous looking forest had the greatest potential of the unexpected...

and therefore decided to require banks to hold the greatest capital when entering the dark scary forest (with its expected risks) than when entering that beautiful field (with its little expected risks).

Smart or extremely dumb?

Extremely dumb no doubt: That's why banks loaded up on what was perceived as safe, like AAA rated securities, like loans to Spanish real estate, like loans to the government of Greece... and do not give loans to those "risky" SMEs and entrepreneurs... who can help or economies to move forward, in order not to stall and not to fall.

The Basel Committee for Banking Supervision’s tragic mistake of doubling down on perceived credit risks

Bankers manage the expected losses by means of perceiving credit risks. And if they are not good at it, they should fail.

Bank regulators on the other hand, need to impose equity requirements on banks to cover for unexpected losses. That is in order to create a buffer between a bank’s operations and the needs for taxpayers’ assistance.

Unfortunately, don’t ask me why, the Basel Committee for Banking Supervision imposed equity requirements on banks that are also based on perceived credit risks, more-risk-more-equity and less-risk-less equity.

That signified a doubling down on credit risk perceptions. And any risk, even when correctly perceived, can create much havoc, if it is given too little or too much importance.

As a consequence current allocations of bank credit to the real economy are utterly distorted, by favoring those perceived as “safe” and punishing those perceived as “risky”.

And also banks will most certainly have insufficient equity to cover for unexpected losses, simply because, the “safer” a borrower seems ex ante, the greater the possibility for the unexpected to cause truly huge disasters, ex post.

And this mistake that has been around for about 25 years, even after disaster struck, is still as of today, not yet even acknowledged by those responsible for it.

Comment on BoE´s Sir Jon Cunliffe´s speech, July 17, 2014, on the leverage ratio in bank regulations.

Sir Jon Cunliffe of the Bank of England, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee, Member of the Prudential Regulatory Authority Board gave a speech on July 17 on the role of the leverage ratio. In it he states: 

“The underlying principle of the Basel 3 risk-weighted capital standards – that a bank’s capital should take account of the riskiness of its assets – remains valid. But it is not enough. Concerns about the vulnerability of risk-weights to ‘model risk’ call for an alternative, simpler lens for measuring bank capital adequacy – one that is not reliant on large numbers of models. 

This is the rationale behind the so-called ‘leverage ratio’ – a simple unweighted ratio of bank’s equity to a measure of their total un-risk-weighted exposures. 

By itself, of course, such a measure would mean banks’ capital was insensitive to risk. For any given level of capital, it would encourage banks to load up on risky assets. 

But alongside the risk-based approach, as an alternative way of measuring capital adequacy, it guards against model risk. This in turn makes the overall capital adequacy framework more robust. 

… bank capital adequacy is subject to different types of risks. It needs to be seen through a variety of lenses. Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk. Using a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk. 

Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank” 

And those assertions contain some important impreciseness and problems on which I must comment. 

First “that a bank’s capital should take account of the riskiness of its assets – remains valid… Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk” 

Absolutely not so! A banks capital should take account of the risk of the bank, which though related to the risk of its assets, is something quite different from the risk of its assets. For instance a bank that has an overconcentration in some few very absolutely safe assets might be infinitely more risky than a bank that has a great diversified exposure to risky assets. The most unfortunate part of current capital requirements is that they are portfolio invariant. 

Second “a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk”.

Not just so! Models are based on expected risks, while leverage ratios should cover primarily for unexpected risks, and “model risks”, the risk of models sometimes not being correct, has even a lot of being an expected risk. And so in this respect the leverage ratio is to cover for much more unknowns than model risk.

Third “Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank”

Not so! What will bite an individual bank has nothing to do with risks, and all to do with its current capital position. If a bank is under the leverage ratio then that is its binding constraint, and if over it, the risk-weighted capital is.

And here is where I need to express my most serious concern with the leverage ratio, and that is that as it increases the floor of minimum capital, it will intensify the distortions produced by risk-weighing. Do you remember the movie the “Drowning pool” where Paul Newman and Joanne Woodward are pressured against the ceiling by an increasing level of water? Precisely that way!

Conclusion: I want a leverage ratio 6-8% but not in the company of the so odiously distorting risk-weights.

This is how are banks are regulated, and how they could have been, if only they listened to what we want our banks do for us.

The pillar of current bank regulations is capital (equity) requirements based on perceived risk. It allows for much lower capital for assets perceived as safe than for assets perceived as risky… which means banks will be able to leverage much more their equity when lending to the safe than when lending to the risky… which means banks will earn much higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… and which means banks will not lend to the risky, like medium and small businesses, entrepreneurs and start ups.

Unfortunately, that will not stop major bank crises, because these result only from excessive exposures to what was wrongly perceived as absolutely safe, and never from excessive exposures to what was ex ante correctly perceived as risky… just like the latest crisis happened.

Had regulators asked us, we would have suggested the following:

First, forget about perceived credit risks. Bankers already consider these when they set interest rates size of exposures and other terms. And if as bankers they are not able to handle credit risk, then it is better their banks go broke, fast, before these grow into too-big-to-fail banks.

Now if you want banks to have capital as a reserve, as you should, set these based on unexpected risks. And since you never really know where these unexpected risks can occur, better set one fix percentage, for instance 8%, against any bank assets.

But also, if you really want banks to help out, then perhaps you could reduce slightly that 8% floor, not based on credit ratings, but based on potential-for-job-creation ratings, or sustainability-of-Mother-Earth ratings. That way banks will be able to earn a little bit more on their equity, when trying to do something good for us.

Because, at the end of the day, what are banks for, if not to help us, our economy and our planet? And by the way doing that is the only way for banks to achieve long term stability. There is no such thing as banks standing intact among economic rubble.

I guarantee you that had bank regulators followed this road, we might have some other type of crisis, but not one as serious as the current one… and definitely banks would be helping out much more in terms of creating jobs for our young, and in terms of helping the environment in many ways.

I ask for your help in putting our banks back on track... current regulators juts refuse to admit their monstrous mistakes... they do not even answer my questions.

In November 1999 in an Op-Ed I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse”… and unfortunately that they keep on doing! Basel III is in many ways only digging our banks deeper into the hole.

“The Parade of the Bankers’ New Clothes Continues: 28 Flawed Claims Debunked” by Anat Admati and Martin Hellwig

I refer here to their revised document of July 6 2014

As I have argued before the authors present a better description than most of the problems of current bank regulations.

Unfortunately, though they correctly identify that relying capital requirements that are risk-weighted is a flawed concept, they do not yet identify the most serious problem with doing so, namely that it dramatically distorts the allocation of bank credit to the real economy.

Since the perceived risks, like for instance those reflected in credit ratings, are already cleared for by means of interest rates, size of exposure and other contract terms, to also clear for the same perceptions of risks in the capital, signifies a double consideration of risk perceptions… and any risk perception, even if absolutely correct, will lead to the wrong conclusions if excessively considered.

In this particular case that signifies that banks will be able to earn much higher risk adjusted returns on equity on assets considered “absolutely safe” than on assets considered “risky”… and that in its turn means that banks will not serve in a fair way the credit needs of those who might most be need in access to it, like medium and small businesses, entrepreneurs and start-ups.

And the main reason for why we ended up with these bad regulations was that nowhere did bank regulators define the purpose of those entities they were regulating.

Another objection to risk-weighing not clearly identified by the authors, is that what regulators really need to consider when setting the capital requirements is not the expected risks or losses, but the unexpected risk and losses. And the Basel Committee, in a document where they explained the methodology of the risk-weighing explicitly stated that, since unexpected risks are hard to measure, they would use the expected risks in substitution of the not-expected… something which of course does not make any sense at all.

The same explicatory document from the Basel Committee on Basel II’s risk weights also states that the capital requirements are portfolio invariant, meaning that they do not consider the risk of over concentrating in what is perceived as safe, nor the benefits of diversifying in what is perceived as risky. And the argument to do so, amazingly, is that otherwise it would be too difficult for regulators to manage the system.

In summary one can say that regulators concentrated on the risks of the assets of the banks, and not on the risk of the banks… which is of course not the same.

Also any empirical study would have shown that bank crises always result from excessive exposures to something perceived as safe... and never from excessive exposures to something perceived as risky. 

Finally, and though there are some other issues I slightly disagree on, let me here conclude with reference to their remarks on:

"Flawed Claim 13: There is not enough equity around for banks to be funding with 30% equity."

"Flawed Claim 14: Because banks cannot raise equity, they will have to shrink if equity requirements are increased, and this will be bad for the economy."

"Flawed Claim 15: Increasing equity requirements would harm economic growth."

I agree with the authors those are mostly flawed claims, but primarily so from the point of view of a static analysis.

But unfortunately, the road from where our banks now find themselves, to where they propose and many would love the banks to be in terms of equity, makes for a very difficult journey.

In my opinion in order to speed up the travelling, before our young  run the risk of becoming a lost generation, will for instance perhaps require awarding special tax exemptions, in order to make those equity increases feasible over a not too long time span…. because we might in fact be talking about at least a trillion dollars of new equity.

And of course, meanwhile, make all fines payable in voting shares.

Please... again...more important than more bank capital is less distorting bank capital requirements.

Fed Chair Janet Yellen has not been briefed on the real implications of current risk-weighted capital requirements for banks.

I refer to Fed Chair Janet L. Yellen speech At the 2014 Michel Camdessus Central Banking Lecture, International Monetary Fund, Washington, D.C. July 2, 2014 on Monetary Policy and Financial Stability.

From it I deduct that she has not yet been fully briefed about the real implications of the pillar of current bank regulations namely the risk-weighted capital requirements for banks.

I will illustrate this with two examples:

First Yellen states: “A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability.”

Absolutely, the problem though is that by means of risk-weighing the capital banks are required to hold, you allow banks to earn different risk-adjusted returns on equity something which stops in the tracks any possibility of efficiently allocating bank credit in ways that permit sturdy economic growth. In essence current requirements, by allowing banks to earn more on the “absolutely safe” it has stopped banks to lend sufficiently to the risky, like medium and small businesses, entrepreneurs and start-ups. And, an economy with insufficient risk-taking, is doomed to recede.

But also, from the perspective of financial stability the current risk weights are completely wrong, since never ever do big bank crises erupt from too much bank exposure to what is ex ante considered risky, they always result from too much bank exposures to what ex ante is considered absolutely safe, but that ex post turns out very risky.

Second Yellen states: “Tools that build resilience aim to make the financial system better able to withstand unexpected adverse developments. For example, requirements to hold sufficient loss-absorbing capital make financial institutions more resilient in the face of unexpected losses.”

Absolutely, the problem though is that the current risk weights have nothing to do with unexpected losses, and all to do with the expected losses derived from the perceived credit risks which are already cleared for in interest rates, size of exposures and other contractual terms.

And the consequence of that is that expected losses get cleared for twice, while the unexpected losses are not considered, and huge distortions ensue.

In the remote possibility that Janet Yellen would read this, let me end here by assuring her that if banks had had to hold the same capital against any asset, for instance the basic Basel II's 8 percent, something else might have happened… but not the current crisis.

PS. Here is a link to a fuller list of the Basel II mistakes.

Mr. Stefan Ingves… I do seriously disagree with your “risk-based capital adequacy ratios”, and I dare you to debate it.

Mr. Stefan Ingves the Chairman of the Basel Committee on Banking Supervision delivered a speech titled “Banking on Leverage" during a High-Level Meeting on Banking Supervision, held Auckland, New Zealand, 25-27 February 2014.

In it Ingves stated: “Risk-based capital adequacy ratios have been the cornerstone of the Basel framework since it was introduced 25 years ago. Capital adequacy ratios measure the extent to which a bank has sufficient capital relative to the risk of its business activities. They are based on a simple principle: that a bank that takes higher risks should have higher capital to compensate. Of course, there are plenty of challenges in measuring risk -- something I will come back to shortly -- but I have yet to meet anyone who seriously disagrees with that simple principle.”

Well I am one who seriously disagrees with that principle… and I dare him to meet me and debate the issue.

A bank, when taking risks, high or low, should compensate for any probable expected losses, by means of interest rates (risk premiums), the size of the exposure, and other terms, like the duration of the loans and guarantees.

And, if the banker does his job well, and adjusts adequately to the risk, then capital has absolutely no role to play in that. And, if the banker does not know how to do his job well, and does not adjust adequately to the risks, then he should fail, the sooner the better for all, so that the bank accumulates as little combustible mistakes as possible.

But a bank regulator, like the Basel Committee, cannot and should not, entirely trust that all risks are being duly perceived by the bankers because, as we all know, there are such things as hidden risks and unexpected losses.

But any hidden risks and unexpected losses cannot be approximated by means of the perceived risks and the expected losses… in fact it is what is perceived as absolutely safe, what is expected to produce the smallest losses, and which therefore can lead to very high bank exposures, which always produce the most dangerous unexpected losses which pose a threat, not only to an individual bank, but to the whole banking system.

And so bank regulators should not require banks to have higher capital to compensate for higher perceived risk, as they do now, but require banks to have a reasonable level of capital in defense of what is not perceived… and since they can not presume to know about the hidden risks of unexpected losses, then they have no other alternative than to set one single capital requirements for all assets, independent of their perceived risks.

To have an idea of how much current risk based capital requirements miss the target, if anything, one could even make an empirical case for setting the capital requirements slightly higher for what is perceived as "absolutely safe" than for what is seen as "risky".   

And that would also eliminate a great source of distortion. The current capital requirements, more perceived risk more capital, less perceived risk less capital, translates into allowing banks to earn much higher risk-adjusted returns on equity on assets deemed as safe, than on assets deemed as risky… and that makes it impossible for banks to perform their function of allocating efficiently bank credit to the real economy.

Basel Committee, Financial Stability Board, know that Your risk-based capital ratios are stopping the banks to finance the risks our future needs to be financed, and only have banks refinancing the safer past. Our young, who now because of your regulations might end up being a lost generation, will hold You all accountable.

As I see it… anyone who allowed banks to leverage 62.5 to 1 on assets, only because these had an AAA rating… or allowed banks to lend to the “infallible sovereigns” against no capital at all, like the Basel Committee allowed for in Basel II, is just not fit to be a regulator. Capisce Mr. Ingves?

PS. Stefan Ingves also states that “The world's largest listed non-financial companies fund their assets around 50:50 with debt and equity. In banking, a more common ratio is 95:5” Let it be clear that 95:5 is 19 to 1 debt to equity… never ever, in the history of banking before the Basel Committee’s risk based capital ratios, have banks remotely been allowed to leverage this much, knowingly.

Will anyone in UK help me file the following complaint against bank regulators through the Financial Conduct Authority?

(As a foreigner not living in the UK, if I filed it, the complaint would probably be ignored)

Below is the link for filing it:

http://www.bankofengland.co.uk/about/Documents/complaints/complaintsform.pdf

The complaint!

Even though bank capital is primarily needed in order to cover for unexpected losses, regulators have set the capital requirements based on the perceptions about expected losses.

And since the perceptions of expected losses are already cleared for by banks by means of interest rates, size of exposure and other terms, this means that perceptions of expected losses get to be considered twice.

And of course that favors those already favored by being perceived as safe, and punishes those already punished by being perceived as risky.

And of course that makes it impossible for banks to allocate credit efficiently to the real economy, with all the negative consequences that entails... among other to the job prospects of the unemployed youth.

And, to top it up, since the capital requirements are portfolio invariant, which means that these do not consider the dangers caused by excessive exposures to what is perceived as absolutely safe but could turn out to be risky, these do not foment the stability of the banking sector. 

On the contrary, these capital requirements guarantee that in the worst case scenarios, which is when banks encounter that something “absolutely safe” has become “risky”, banks will have too little capital to respond with.

These regulations are therefore destructive and should be changed.

What a bank regulator could be asking himself on his deathbed…

Even though I knew that the capital I should require a bank to hold was primarily a protection against unexpected losses… how could I have been so dumb so as to base the capital requirements on the perceptions about the expected losses?

And how could I have been so dumb so as to accept “portfolio invariant” capital requirements, which obviously does not consider the danger of excessive exposures to what is perceived as “absolutely safe”, nor the benefits of diversification among what is considered as “risky”?

That caused of course banks to make much much higher risk-adjusted returns on equity when lending to “the infallible sovereigns” and the AAAristocracy than when lending to the “Risky”.

And that caused banks to overpopulate some “safe havens” turning these into deadly traps, like AAA rated securities, Greece, real estate in Spain; and equally dangerously to under-explore the more risky but more productive bays, represented by medium and small businesses, the entrepreneurs and the start-ups.

And with all that I helped to screw up the whole Western world economy... especially Europe's

I know most of the world will not forgive me, but I sure pray for that my unemployed children and grandchildren understand that, though admittedly I was very dumb and arrogant, I did not regulate so dumb on purpose… in fact my whole problem began when I and my colleagues started to regulate the banks without even caring to define their purpose.

A simple question, on bank regulations, to Basel Committee, Financial Stability Board, FED, ECB, FDIC, PRA and other

Do you really believe that those “unexpected losses” which could destabilize the banking system, should be estimated based on the estimations of “expected losses”? 

I ask that because that is what you have, in my opinion irresponsibly so, bet our whole banking system on... in fact even bet the health of our real economy on.

The capital requirements for banks should primarily cover for any unexpected losses, as any expected losses should primarily be covered by bankers knowing what they are doing. But, by your own confessions you have based the unexpected losses on the perceived risk of expected losses, like those contained in a credit rating. And that leads to the expected losses to be counted twice, while the unexpected losses are not considered at all.

And to top it up your current capital requirements for banks are, again by your own confessions, “portfolio invariant”, which means that the benefits of asset diversification among “the risky” or the dangers of excessive concentration of assets to something perceived as “absolutely safe” are not considered at all.

What you have done allow the banks to earn much higher risk-adjusted returns on capital when lending to The Infallible than when lending to The Risky, and this seriously distorts the allocation of bank credit in the real economy, with tragic implications for its future health.

And all for nothing, because you should know that what can cause the unexpected losses that can really bring a banking system down, are really to be found among what is perceived to generate the lowest expected losses.

What can I say regulators? That you have no idea of what you are up to? Frankly, I can’t find any other explanation.

You have a lot of explaining to do all that unemployed youth that you might turn into a lost generation. 

You fill pages after pages with talk about prudential regulations, but let me remind you of that the first rule of prudence is to cause not even larger damages! And that you have done.

Current regulators in the Basel Committee, and in the Financial Stability Board need to be fired!

Bankers are expected to guard the front door from all expected losses entering their business, and this they do by means of interest rates, size of exposures and other terms. Though sometimes one or another banker fails in doing that, in general, as a system, they perform quite well.

But the banker cannot guard the back-door, that of the unexpected losses too, because were he to do so, he would not be able to attend competitively his ordinary business at the front door.

And so it is the regulators’ responsibility to make sure that the back door is sufficiently guarded. Unfortunately, current regulators, explicitly for reasons of simplicity, stupidly decided to guard against unexpected losses, with a wall which height was determined based on the perceptions of expected losses.

And to top it up, also explicitly for reasons of simplicity, they decided And that means that “expected losses” are considered twice, while the “unexpected losses” are ignored.

And that means that the banking system overdoses on perceptions of expected losses, something which make it impossible for banks to allocate credit efficiently in the real economy.

And that means that when some unexpected losses occur, usually in assets previously deemed as safe, the risk of banks not having sufficient capital has dramatically increased.

The leverage ratio, that which is not based on risk-weights, was to partially solve one problem, though of course that of the distortion would remain, as other risk-weighted capital requirements would still be in place.

But the way the Basel Committee seems now proceeding to dilute the leverage ratio, seemingly even introducing risk-weighting for off-balance sheet items, while if something needed to be diluted was the discriminations produced by risk-weights, is evidence that the regulators really do not know what they are doing. And it therefore behooves us to fire them… urgently.